Spencer Dale: Inflation targeting and the Monetary Policy Committee’s forward guidance Speech by Mr Spencer Dale, Executive Director, Monetary Policy, and Chief Economist of the Bank of England, at the International Journal of Central Banking Annual Conference, “Inflation targeting and its discontents”, Warsaw, 6 September 2013. * * * A central theme of this conference has been to highlight potential shortcomings of inflation targeting and to consider potential alternatives. I believe that the traumatic events in the UK economy over the past five years have, in fact, strengthened the case for inflation targeting. The credibility of the inflation target has played a crucial role in anchoring inflation expectations over the past five years, a period in which inflation has been consistently above target. That credibility has been vital in giving the Monetary Policy Committee (MPC) the flexibility to loosen monetary policy aggressively in order to support growth and jobs. But while it has not constrained the MPC’s freedom to act in support of the economy, the inflation target, on its own, has proved less well suited to addressing some of the exceptional communications challenges posed by the sustained combination of weak growth and elevated inflation. I would highlight two in particular: the need to make clear the central role that monetary policy has played in supporting output and employment; and the need to provide guidance about the Committee’s view of the appropriate trade-off between bringing inflation back to target and stimulating the recovery. The forward guidance provided by the Committee in August can be seen as a response to these challenges. To retain the clarity and credibility of the inflation target but to augment the framework so that monetary policy is better equipped to address the exceptional challenges currently faced by the UK economy. In this talk, I will provide a post-crisis report card for the UK’s inflation targeting regime and explain how the MPC’s forward guidance responds to some of the areas exposed as having ‘room for improvement’. I will also show how a threshold for monetary policy defined in terms of the unemployment rate is particularly helpful in addressing two other challenges currently facing the MPC: the uncertainty surrounding the future path of productivity; and the need to provide greater clarity concerning the setting of monetary policy as the economy recovers. A bit of background Before doing so, it is worth highlighting three features of the UK’s economic performance over the past five years which should be borne in mind when evaluating the performance of the UK’s inflation targeting framework and understanding the Committee’s decision to provide forward rate guidance. First, CPI inflation has been above target for almost this entire period (Chart 1). Fifty four months out of the past sixty to be precise. Over this period, CPI inflation has averaged 3%. And, on the basis of the MPC’s central projection in the August Inflation Report, it is expected to remain above target until the second-half of 2015. Second, notwithstanding the recent encouraging data, the recovery following the crisis has proved exceptionally weak. The level of UK GDP is still more than 3% below its pre-crisis level. This is the weakest UK recovery on record. And with the exception of Italy, the weakest across the G7 (Chart 2). Third, the sluggish recovery has been accompanied by extraordinary weakness in productivity. The level of private sector productivity has actually fallen over the past five BIS central bankers’ speeches 1 years: the first time since the late 1800s that productivity has fallen over such a timeframe other than as a result of economic demobilisation following the World Wars (Chart 3). High inflation, anaemic demand and even weaker supply: an extraordinarily challenging economic backdrop against which to set monetary policy. So how did the UK’s inflation targeting framework stand up to this challenge? A post-crisis report card for UK inflation targeting In short, a bit like my old school reports: good, but could do even better. The regime’s main success is that inflation expectations have remained well-anchored despite the sustained period of above target inflation. There is no definitive test or measure of the stability of inflation expectations. But evaluating a wide range of expectations measures along a number of different dimensions presents little evidence that the stability of inflation expectations has lessened to any material extent.1 This stability is all the more striking given that monetary policy was loosened very aggressively during this period. As has been discussed before by many of my MPC colleagues (see, for example, Bean (2011), Broadbent (2011), Fisher (2013)), to not have done so would have meant presiding over an even deeper recession and an even greater rise in unemployment. Rather than a constraint as some claimed, the inflation target and the credibility it afforded were essential in allowing the MPC to respond as forcefully as we did. The much vaunted flexibility offered by inflation targeting frameworks – to set policy in such a way that mitigates damaging booms and busts in activity as well as controlling inflation – can be exercised only if policymakers’ commitment to their target remains credible. Without credibility, there can be no flexibility. The experience of the UK economy over the past 5 years has provided a real-time examination as to how long inflation can remain above an explicit policy target without the credibility of that target being undermined. Thus far, the UK’s inflation target has passed this test with flying colours. And, in so doing, it has enabled the MPC to provide vital support to our economy. But although inflation targeting scored highly against its primary objective – anchoring people’s inflation expectations – there was, as my teachers used to say, some room for improvement. For me it was speling. For inflation targeting, at least as operated in the UK, it was in addressing some of the communications challenges posed by the sustained period of weak demand and elevated inflation. Room for improvement: explaining our policy choices The public emphasis that we, as inflation targeters, place on achieving outcomes for inflation plays a key role in underpinning the MPC’s anti-inflation credentials. But this focus can be a double-edged sword, in that it can give the false impression that inflation is the sole focus of our monetary policy. In fact, over recent years nothing could have been further from the truth. Indeed, inflation has been above target for the vast majority of the period since the financial crisis. Yes: some of this inflation overshoot might be the result of poor forecasting. For much of this period, the Committee expected inflation to fall back to target more quickly than it actually did. But much more important was the recognition that a lower profile for inflation was possible only by tightening monetary policy at the expense of an even deeper recession and an even greater rise in unemployment. Throughout this exceptionally challenging period, monetary policy has 1 See Bank of England Quarterly Bulletin 2013 Q2 and recent Inflation Reports for a detailed analysis of recent movements in inflation expectations. 2 BIS central bankers’ speeches consistently been set to ensure that inflation remains on track to return to the 2% target in the medium term. But, subject to that, we have done everything in our power to support the UK economy through the aftermath of the financial crisis, using the flexibility afforded to us by the inflation targeting framework and by our own credibility to the full. But the nature of our inflation targeting framework – with the primacy it attaches to the control of inflation – means it is not well suited to explaining our role in supporting growth and jobs. Policy actions have typically been explained solely in terms of inflation: for example, reducing the risk that inflation will undershoot the target in the medium term or extending the horizon over which we intend to return inflation to target. Although, technically accurate, such explanations don’t speak to the distress of businessmen and women worrying about the future of their companies or to the anxiety faced by families unsure as to whether they will still be in a job next week. Make no mistake: inflation targeting provides the flexibility for policy to respond to such anxieties. And we have fully exploited that flexibility over recent years. But it doesn’t provide a natural framework – a ready vocabulary – in which this flexibility can be clearly communicated. This almost exclusive focus on inflation in our communications didn’t matter for much of the first 20 years of inflation targeting in the UK. Indeed, arguably it was one of its attractions. Prior to the introduction of inflation targeting in 1992, the UK had searched – in vain – to find a credible anchor for monetary policy and inflation expectations. The simplicity and clarity provided by a numerical target for inflation helped to establish the credibility of monetary policy and was instrumental in fostering the period of stable growth and low inflation enjoyed in the decade or so prior to the financial crisis. But in the aftermath of the crisis and faced with five years of almost no growth, it is natural for people to ask what monetary policy is doing to help get the economy going. The control of inflation is important but so too is supporting the creation of jobs as unemployment rose to its highest level for almost twenty years. There was a real risk that this would start to erode the trust and support of inflation targeting; to damage its democratic legitimacy. This was arguably evident earlier this year in the discussions in the media and amongst some commentators as to whether the framework of monetary policy should be altered, say to adopt a nominal GDP target or for the MPC to have an explicit objective for growth.